Morningstar - Q2 2021 - 37

to benchmarks and are more unconstrained. That
being said, our strategies tend to move in
similar directions. As equity valuations became
more and more stretched in the periods leading up
to 2020, we generally trimmed our exposure
to stocks to underweight positioning. Then, when
the COVID-driven sell-off occurred in Q1 2020,
we saw the long-term risk/reward trade-off
of equities as quite attractive given the depressed
prices. Therefore, we took the opportunity
to increase our equity exposure, and we
have generally maintained those allocations
since then.
Q: How have you adjusted your allocations
within fixed-income and equities? Where are
the opportunities?

A: The answer to this can change relatively
dramatically in a short period of time in the volatile
environment we have been in for the last
12 to 15 months. After the drawdown period in
Q1 2020, we saw opportunities in broad
equities and credit assets like high-yield bonds
and investment-grade corporates, as well
as emerging-markets debt. We also believed that
valuations looked particularly attractive in
cyclical equity sectors like energy and financials.
Given the record-breaking rebound, a lot
of those opportunities have closed or shrunk.
We still see pockets of opportunity within
equities outside of the United States as well as
within some of the economically sensitive
sectors. The opportunities in fixed income are
less attractive, though we do see some
value in local-currency emerging-markets debt.
Q: What is your goal when building a diversified
portfolio? What are your measures of success?
Has bonds' role as effective diversifiers declined?

A: Regardless of the strategy type, the general
idea behind building a diversified portfolio is to
ensure that the underlying asset classes within the
portfolio are positioned to respond to distinct
market factors and behave differently, especially
in extreme market environments. We want
to make sure that one or two fundamental factors
do not determine our portfolio-level wins
and losses. This requires a deep understanding
of the fundamental drivers of return for each
asset class, and how they interact in different
market environments.

The efficacy of bonds being effective diversifiers
in a multi-asset portfolio can change over
time depending on the level of interest rates and
the shape of the yield curve. It can also vary
depending on what else is held in a portfolio.
For example, 2020 proved to be a good
year for investors who owned long-term Treasury
bonds, which gained 8.5% as the S&P 500
sold off by more than 30% during the Q1 2020
drawdown. This was the result of typical
investor behavior: During an equity sell-off,
investors often rush to dial down risk by selling
equities and investing in " safer " assets like
Treasury bonds, which pushes interest rates lower.
Treasury bonds, especially the ones in the
intermediate- and long-term maturity buckets
(those with longer durations) benefited in
this environment and helped offset losses from
the equity side in a multi-asset portfolio.

Q: Should investors who need to live off their
investments focus on income or total return?

A: Morningstar Investment Management recently
conducted an income study comparing two
popular approaches: an income strategy versus
a total-return strategy. The results show that
both have merit and should be considered viable
options for income-seeking investors.

In this study, we used historical data and backtested for both approaches. The key considerations
that we explored include income stability,
the source of withdrawals, and the likely end
account value. We also considered taxation
and behavioral issues.
We found that both approaches were able
to consistently meet retirees' distribution
needs through all market environments-

The efficacy of bonds being effective diversifiers
in a multi-asset portfolio can change over time...

With rates at record low levels, the potential
for price increases today is definitely
more limited than it was 20 years ago, when
10-year Treasury yields were around 5%
to 6%. When adjusting the equity exposure
in a multi-asset portfolio, we don't just
look at equity opportunities in isolation. We
also consider the duration positioning
of the portfolio on the fixed-income side to help
ensure we have the appropriate level of
hedging in place in response to any change
on the equity side. More recently, with the
yield curve steepening as yields on the
longer end of the curve rise, we see the value
of bonds as a hedging tool against equity
and credit risks improving, especially
for portfolios with a cyclical equity overweight,
which tend to have a higher correlation to
rates movement.

even in the current low interest-rate environment.
If the investor prefers a large ending account
value for estate-planning purposes, then
an income approach might work better. On the
other hand, if tax is a key concern, then
a total-return approach should be considered.
There are also behavioral considerations. Investors
with strong negative feelings about dipping
into principal, especially when the market
experiences severe downturns, should be cautious
about using the total-return approach.
Overall, we believe there is no one best choice that
works for everyone. Ultimately, retirees must
balance the pros and cons of each approach and
make the right choice for themselves. K
Jerry Kerns is editor in chief of Morningstar magazine.

morningstar.com/lp/magazine

37


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Morningstar - Q2 2021

Table of Contents for the Digital Edition of Morningstar - Q2 2021

Contents
Morningstar - Q2 2021 - Cover1
Morningstar - Q2 2021 - Cover2
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